Will ratings hinder reinsurer M&A and the hedge fund ‘play’?

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In the investment banker ‘101’ playbook for cyclical industries the reinsurance industry has arrived at the page marked ‘weak pricing due to too much competition; sell M&A services to our clients’.

This, if you are a banker, can be a very nice place to be. Less so of course for those clients that are the potential targets given that the ‘M’ in ‘M&A’ is rarely more than a fig leaf, but still there’s good money to be made advising the defenders.

Of course, an industry whose productive capacity is capital itself shouldn’t really be cyclical at all. There are no multi-year product development cycles, or billions locked up in factories, plant and machinery that have to be either ‘sweated’ or written-off. A ‘rational’ reinsurance player can reduce volumes in a poorly priced market with an ease unheard of in most of business life.

Nonetheless cyclicality seems to prevail.

One could argue that since the current excess capacity is in part driven by the influx of ‘alternative capital’ what we are actually seeing is this driving a disruptive industry change to reduced pricing through a lower cost of capital rather than simply cyclical behaviour.

More generally, as Aon recently reported, there are ways for the traditional market to access that cheaper capital too. If everybody’s capital gets cheaper then RoE targets should reduce (again meaning part of the pricing reductions could be structural not cyclical).

That said, few seem to actually believe that current pricing is sufficient.

So, for now at least, the mantra for many is ‘find more return’; either by consolidation, or pursuing more aggressive ‘hedge fund type’ investment strategies. Neither will be easily sold to the rating agencies. Reinsurer M&A in a softening market has not always been a runaway success to put it mildly; the business case will not be easily made to the agency.

Increased market power can be a plus but it takes real scale in the reinsurance market for this to be much better than a neutral factor for a rating.

Cost efficiencies, if that’s the plan, are a positive of course but few reinsurer ratings are heavily influenced by this for the simple reason that – in a volatility based business – it’s management of that volatility (i.e. capital, underwriting and ERM) that drives the credit risk profile, not whether a reinsurer has rather overdone it in staffing up the marketing department.

Capital (rather than cost) efficiencies can work in the diversification sense; buying a well-established book is generally seen as less risky – reserve adequacy permitting – than organic diversification thanks to the avoidance of the anti-selection risk faced by new market entrants.

But if, one way or another, the plan involves a more aggressive use of the post-acquisition combined capital than that of the pre-acquisition acquirer, the conversation with the agency may not be straightforward.

Add to that the agencies’ inevitable concerns about execution risk and whether the acquired reserves are indeed adequate, and acquisitions at this point of the cycle (that are anything much more than ’bolt –ons’), can need some very persuasive logic to support the acquirer’s rating.

But what about ignoring the Banker’s siren calls and instead enhance returns via a hedge fund type investment strategy? Indeed this appears to being talked up as the industry trend ‘du jour’.

The logic is straightforward; while current reinsurance pricing limits healthy RoE’s the business still has the happy outcome of generating investable premiums up-front. So, find a friendly hedge fund to spice up the investment strategy, focus on longer tail lines, and watch those enhanced returns roll-in.

Simple!

We are reminded of the 1980’s rhetoric of some Lloyd’s members’ agencies to prospective individual Names; “support your underwriting at Lloyd’s via a bank LOC based on your assets and – shazaam – you magically get to use your capital twice!”. The accompanying reality that, by doing so, the Name also had the privilege of risking their capital twice somehow seemed to get lost.

Not only was this ‘implied financial alchemy’ message successfully sold to non-experts, many industry participants fervently saw it that way themselves.

That seems bizarre with hindsight, but these things always do.

Yet a reinsurer actively pursuing a more aggressive investment strategy is doing exactly this; using and risking its capital twice. And that is how the rating agencies will look at it.

More investment risk may or may not make sense in any given case but it is no generic solution to the problem of under-priced reinsurance.

To be fair, the expert asset management professionals involved will stress that it’s a lot, lot cleverer than that. Asset/liability portfolio management can optimise the risk/return trade off and that’s the name of the game, but that’s a very hard trick to pull off in practice when a large part of that risk is derived from a soft reinsurance market.

Not that a case to the agency cannot be made, but demonstrating control of underwriting risk and pricing will, as ever, be crucial. Writing for volume becomes a lot more enticing when the expected investment return goes up, and the agencies know that.

We recently read of one asset manager from a leading global firm who believes this trend will mean the agencies will have to adapt how they look at asset and liability risk when running their capital models on reinsurers. Since the agency models have long factored investment exposures into their risk adjusted capital adequacy calculations we assume he means model changes would be needed to reflect the enhanced portfolio effect of ALM driven reinsurer investment strategies.

We suspect he will be disappointed. The last time the agencies allowed clever portfolio model analysis to mitigate the volatility of what were otherwise clearly high risk assets they ended up giving AAA ratings to pools of mortgages taken out by unemployed Americans.